The Relationship Between Systematic Risk and Diversification

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The Relationship between Systematic Risk and International

Diversification: An Empirical Inquiry


I.               INTRODUCTION

Foreign investment has grown rapidly over the last thirty years. The total value of global investment was estimated at $105 billion in 1967. By 1984, it had surged to an estimated $596 billion, and by 2005 it was estimated at $9 trillion (United Nations 2005). U.S. firms have also substantially expanded their oversea investments as evidenced by the more than 700 percent growth in foreign sales (World Trade Organization 2000). In addition, S&P 500 firms report that foreign sales, on average, account for more than 24 percent of total sales (Duru and Reeb 2002). This growth in international presence has spawned considerable regulatory and academic interest in the impact of internationalization on systematic risk and firm characteristics. A number of academic studies suggest that risk is a key factor in international diversification decisions (Agmon and Lessard 1977; Clarkson, Guedes and Thompson 1996). This paper investigates the nature and form of the relationship between corporate international diversification and systematic risk (beta). The form the relation takes is important to the determination of optimal level(s) of investment, which also impacts the economic value of the firm[1]. The form, however, is relevant beyond the determination of optimal level of investment context. For example, the Security and Exchange Commission (SEC) requires all large U.S. publicly traded corporations to disclose quantitative information about their market risk in financial statements filed with the SEC.[2]

         Recent empirical studies find that the average global diversified firms experience higher systematic risk relative to domestic firms. This literature also suggests that international diversification at higher ranges might also reduce systematic risk primarily because of the overall affect on cash flows.   For example, Mansi and...